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Financial System Report (October 2016)

October 24, 2016
Bank of Japan

Contents

Executive summary: comprehensive assessment of the financial system

Developments in financial markets

In global financial markets, while investors' risk aversion temporarily heightened following the result of the U.K. referendum in late June -- in which a majority voted to leave the European Union (EU) -- calm gradually returned to markets thereafter. There are signs that search for yield activities are becoming active again, against the background of advanced economies' long-term interest rates at low levels. Careful attention should thus be paid to whether global fund flows suddenly change. Meanwhile, although there were phases during which developments overseas affected Japanese markets as seen particularly in stock price declines and the continued appreciation of the yen, highly accommodative financial conditions have been maintained with the Bank of Japan's introduction of "Quantitative and Qualitative Monetary Easing (QQE) with Yield Curve Control" in September 2016.

Examination of financial intermediation

The year-on-year growth rate in financial institutions' domestic loans outstanding has been around 2 percent, amid accommodative lending stances among financial institutions and demand for funds from a wide range of industries. Similarly, overseas loans have continued to show relatively high growth, particularly loans to advanced economies such as North America. As for securities investment, financial institutions have been stepping up their investments in risky assets, such as foreign bonds and investment trusts, while outstanding holdings of yen-denominated bonds remain at a high level. Institutional investors -- such as insurance companies and pension funds -- and depository institutions with a focus on market investment -- such as Japan Post Bank and central organizations of financial cooperatives -- have further increased their propensity to accumulate foreign bonds and other risky assets. Meanwhile, with regard to households' investment activities, moves to diversify their asset portfolios have lost momentum somewhat since the summer of 2015, partly due to the effects of lower stock prices and the stronger yen. In terms of financial intermediation through financial markets, equity financing has been lackluster against the backdrop of volatile stock prices, while an increasing number of firms have issued super-long-term bonds against the background of favorable issuing conditions in the corporate bond market. Under these circumstances, the funding environment among firms and households has been highly accommodative.

In light of the above financial intermediary activities, signs of overheating, such as excessive risk taking and credit growth, have not been observed on the whole. Nevertheless, amid the continued low interest rate environment, banks have adopted the most proactive lending stance since the bubble period. Banks' increasingly proactive lending stance serves as an important transmission channel for monetary easing effects. However, if competition among financial institutions overly intensifies, banks' profit bases could become vulnerable, particularly through a deterioration in profitability on loans, bringing about financial system instability risks. Forthcoming developments in this regard therefore require careful vigilance. In addition, although the real estate market currently does not appear to show signs of overheating on the whole, it has been observed that some transactions in metropolitan areas took place at lofty prices and came with low investment yields, and the growth rate of banks' real estate loans has increased. Going forward, it is necessary to carefully examine whether capitalization rates among investors are declining excessively, or whether the occurrence of transactions executed at lofty prices is expanding to other regions.

Stability of the financial system

Japan's financial system has been maintaining stability. Indeed, financial institutions' capital adequacy ratios are sufficiently above regulatory requirements, and their capital levels are generally adequate relative to the amount of macro risks undertaken. The results of macro stress testing indicate that Japan's financial system is considered to have generally strong resilience against stresses. In terms of liquidity, financial institutions have sufficient yen funding liquidity. With regard to foreign currency liquidity, they have a liquidity buffer that can cover funding shortages, even if funding conditions become difficult for a certain period. It can also be confirmed that the soundness of financial institutions is sustained, even under a stress scenario where they cannot avoid the disposal of foreign currency-denominated assets. Nevertheless, financial institutions need to continue with efforts to bolster their stable foreign currency funding bases, as the share of market funding in their foreign currency funding is still large.

Potential vulnerabilities due to the decline in financial institutions' profitability

Financial institutions have sufficient capital bases at present, which will allow them to continue risk taking even if profitability remains subject to downward pressure for the time being. Going forward, if their portfolio rebalancing leads to an improvement in economic and price developments, this is in turn likely to bring about a recovery in core profitability. However, structural problems such as further population decline and aging are expected to continue exerting downward pressure on the profitability of regional financial institutions' deposit-taking and lending activities. Under these circumstances, if the effects of negative interest rates are included and the recent trend of declining profits persists, the number of financial institutions experiencing an erosion of their loss-absorbing capacity could increase, leading to a weakening in the financial intermediation function.

At the same time, it is necessary to pay attention to the possibility that financial system stability will be impaired, in a case where financial institutions shift toward excessive risk taking, in view of maintaining their profitability, amid a decline in the profitability of their loans and securities investment mainly due to the effects of the negative interest rates.

As such, regarding potential vulnerabilities due to the declining profitability of financial institutions, it is necessary to examine both the risk of overheating -- excessive accumulation of macro risks and exuberant asset prices -- and the risk of a gradual pullback in financial intermediation due to a persistent decline in profits.

Challenges from a macroprudential perspective

In order for Japan's financial system to ensure stability in the future, it is essential that financial institutions steadily respond to the accumulation of risks and structural changes that could become a source of potential vulnerability. To address declining profitability, they are expected to formulate business plans to stabilize and improve their profitability through, for example, strengthening their support for the regional economy and local firms, by enhancing financial intermediation capabilities. Another important challenge is to strengthen the ability to respond to risks in areas where Japanese financial institutions are proactively stepping up their risk taking, such as overseas business and market investment. In addition, given the increasing systemic importance of large financial institutions, further action is called for. This includes establishing a solid financial base and strengthening business management frameworks to respond to the accumulation of risks, as well as making preparations to respond in an orderly manner in times of stress. The Bank will continue to deal with these challenges on its part toward ensuring financial system stability, through its off-site monitoring and on-site examinations, among other efforts.

Notice

This Report basically uses data available as at September 30, 2016.

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Inquiries

Financial System Research Division, Financial System and Bank Examination Department

E-mail : post.bsd1@boj.or.jp